The U.S. deficit

A trade balance showed a gap of $30 billion. By the end of that year, the gap widened by a little over one third to around $40 billion. Between February and November 2004, the gap surged from $42.1 billion to $60.3 billion.

The easiest way of dealing with this problem is the devaluation of the dollar, but selling the dollar is not always as easy as it should be.

Traditionally, the currency that had to be bought against the dollar was the Japanese yen, as exports loving Japan enjoyed asymmetrically large trade surpluses. But once the U.S. dollar/Japanese yen (USD/JPY) collapsed to the 80 area in spring 1995, the shock was so big on both sides of the Pacific that once the exchange rate rebalanced, no one uttered a word about a “structural problem.” So, when the Bank of Japan bought unprecedented amounts of dollars during the second half of 2003 and the first quarter of 2004, there was little complaint from U.S. officials.

The problem is in November 2004 the trade deficit with China reached $16.6 billion — a little more than a quarter of the total U.S. trade gap.

Perhaps the U.S. would now love to further debase the dollar against the currency that causes most of the problem — the Chinese yuan. However, the yuan does not float freely — it is pegged to the dollar. Because the markets cannot possibly exercise their role of shock absorber without free-floating rates, the only way to achieve the same result is for China to revalue its own currency.

Rumors have abounded that China will adjust the yuan by the beginning of 2005, but nothing has happened (no surprise there). It’s very hard to gauge what would make China listen to the needs of the G7 economies, particularly since it holds the key to negotiations between North Korea and the U.S. on nuclear weapons, and it also wants to weaken Taiwan.

Otherwise, there is the risk Japan will feel it doesn’t have to allow the yen to strengthen below parity (100) with the dollar to single-handedly expose its exports to lower profits. This would translate into another set of massive interventions by the Bank of Japan, and even the Federal Reserve of New York might be convinced to make a mild contribution to propping up the dollar.